The Paul Volcker Myth

With not an insignificant amount of fanfare last week, former Fed Chairman Paul Volcker endorsed Barack Obama’s presidential candidacy. His endorsement drew more attention than it normally might have in that while Volcker is a lifelong Democrat, his legend is inextricably linked to Ronald Reagan’s, and the ‘80s economic revolution that reversed the U.S.’s flagging economic fortunes.

Given Volcker’s historical ties to Reagan, some Republicans logically took offense to his seeming apostasy. Their dismay is misplaced. Volcker was never on board with the Reagan economic plan in the way that modern history suggests, and rather than an essential driver of the ‘80s economic renaissance, a more realistic account of Volcker’s early years at the Fed shows that far from a facilitator of pro-growth policies, Volcker’s actions nearly derailed Reagan’s economic plan and presidency altogether.

Though Reagan spoke confidently of renewed economic optimism that would result from tax cuts, Volcker’s countenance was very dark, with frequent pronunciations about us not being so naïve as to assume “there are quick and painless solutions” to the economic problems we faced. To Volcker, there was no way we could “avoid a clash between monetary restraint….and the growth of economic activity;” this despite the truth that growing economies require more money, not less.

Given his skeptical views about the Reagan tax cuts, Volcker lobbied in secret against their passage owing to his view that they would lead to a massive revenue shortfall. While Fed Chairman Fred Schultz worked on House members, Volcker lobbied senators to vote against the cuts.

As George Schultz told William Greider in Secrets of the Temple, Volcker’s position was that, “We are in favor of a tax cut, but you must recognize that if you can’t accomplish this with much bigger budget cuts than you are contemplating, it’s going to put much more pressure on us and that means higher interest rates.” Shades of Robert Rubin.

Using his control of the interest rate lever as a weapon, Volcker kept money “tight” in order to prize tax increases out of the White House. More on monetary policy later, but bad dollar policy brought on the ’81-’82 recession, and remarkably led to a bill that increased taxes ahead of the 1982 elections. Unsurprisingly, the Republicans lost 26 House seats.

Even more galling, according to Paul Craig Roberts’ The Supply-Side Revolution, not a single Democrat voted for the tax increase. None needed to in that as Mark Shields wrote in the Washington Post at the time, Reagan’s advisors (including Volcker) did all of their dirty work for them in terms of attracting Republican votes in favor of tax increases. Thanks to economic advisors that did not share Reagan’s optimism about tax cuts, by 1983 the Reagan tax cuts of ’81 had disappeared in dollar terms. The marginal incentives of course remained, but due to powerful opposition on the part of Volcker, Alan Greenspan and others, Reagan’s tax program was severely compromised.

In his most recent column, George Will continued the false legend concerning Volcker, noting that he and President Reagan whipped the inflationary dragon with contractionary economic policy that resulted in double-digit unemployment. Will’s thinking resembles that of our present Fed Chairman who labors under the retro view that growth is the cause of, not the cure for inflation. The truth about Reagan vis-à-vis Volcker when it comes to inflation is a bit more nuanced.

A Carter appointee, Volcker’s attempts to use interest-rate increases to slay inflation in the late ‘70s were met with a great deal more inflation. By February of 1980, with the Fed funds rate at 14 percent, gold hit an all-time high of $875/ounce.

The dollar’s aforementioned fall was of course sped along by another major mistake carried out by Volcker just a few months prior. Correctly recognizing the futility of interest-rate targeting, Volcker shed the latter only to make a fateful decision that would drive the U.S. economy even further into the ditch. Put simply, in October of 1979 Volcker began a three year experiment with Milton Friedman’s monetarism.

Instead of targeting the Fed funds rate, Volcker attempted to target the quantity of money with disastrous consequences. Though inflation is surely a monetary phenomenon as Friedman long noted, with the majority of physical dollars outside these fifty states, attempts to control the quantity of dollars within these fifty states were bound to fail. To the extent that the Fed targeted various aggregates of U.S. money supply lower, this merely meant that dollars in other markets (eurodollars for instance) would fill the shortfall.

Worse, given the Fed’s efforts to control money quantity rather than rates, the Fed funds rate bounced around on a daily basis such that businesses faced an impossible task of raising capital owing to uncertainty about the rate at which they could raise capital. As Charles Kadlec and Arthur Laffer wrote at the time, “the Fed’s action reduced the viability and attractiveness of the dollar,” and as a result its policies “increased the prospects of inflation” in spite of the fact that monetarist targets “resulted in a slower growth in the measured quantity of money.” What the economy needed according to Laffer and Kadlec were “policies that lead to an excess demand for dollars relative to their supply.”

Those policies did materialize, but no thanks to Paul Volcker. Though the dollar hit what was until recently an all-time low under Volcker in February of 1980, positive electoral developments began to reveal themselves which succeeded in arresting the dollar’s fall.

In short, by the spring of 1980 the markets started to price in Ronald Reagan’s election. Reagan of course ran on a pro-growth platform of further de-regulation, tax cuts, and a return to a more stable and stronger dollar. And economic growth, if it has any effect, serves to soak up excess liquidity. With investors pricing in a brighter economic future, gold was down to $600/ounce by election day in 1980, and by the end of 1981, the yellow metal had fallen below $400.

Contrary to modern accounts of that period suggesting Volcker’s policies whipped inflation, the markets had as mentioned already “voted” on them with gold having reached an all-time high in his early years at the Fed. The weak dollar that gold signaled was itself inflation, not a cause of the latter, and with Reagan’s election and its policy aftermath having boosted the dollar, inflation was effectively contained.

Sadly, Volcker did not agree. Seeking to tighten further through futile attempts at managing the various monetary aggregates, his actions sent the economy into a major recession which led to the ’82 electoral rout, and which made Reagan’s 1984 re-election prospects increasingly dicey. Worse for the Reagan program, Alan Greenspan and Herbert Stein gave Volcker enhanced political cover given their view that the tax cuts themselves would be inflationary.

So rather than accommodating the Reagan tax cuts with increased liquidity, Volcker went in the opposite direction until a looming Mexican loan default threatened the worldwide banking system. The time was October of 1982, and on October 9th of that year Volcker finally abandoned the monetarist approach to Fed policy that had proven so disastrous.

The resulting expansion of dollar liquidity did not prove inflationary as so many (including Milton Friedman) assumed it would, because by 1983 the marginal tax cuts Reagan had championed fully kicked in. Contrary to suggestions today that say tax cuts are slow to impact the economy, a combination of lower rates and increased dollar liquidity Fed an economic boom that led to Ronald Reagan’s landslide re-election in 1984.

Still, the Reagan Revolution almost never was, and Paul Volcker’s 6’7” frame weighed on it like no other politician or government policy. If he should be given any credit for Ronald Reagan’s successes, it would have to do with his belated admission in 1982 that his policies were hammering the economy along with Reagan’s economic program. And it was the latter that whipped inflation, not Paul Volcker.

All this in mind, no one should be surprised by Volcker’s endorsement of Barack Obama. Despite the truth that Reagan’s visions elevated him to central-banker sainthood, he never agreed with the vision. As such, his embrace of the Illinois senator isn't newsworthy in the least.